Friday, April 15, 2016

SEC Chair White and the Evolving Role of Fund Directors

Author: David Schwartz J.D. CPA

In her March 29, 2016 keynote address before the Mutual Fund Directors Forum’s annual policy conference, SEC Chair Mary Jo White laid out some of her thoughts on the role of mutual fund directors in assessing risks and exercising their oversight responsibilities.  In addition, she highlighted recent changes in markets and regulation affecting the role of fund directors, as well as some of the potential challenges ahead. 


Chairman White started out her speech by discussing what makes mutual fund directors special.  Because mutual funds rely on service providers and advisers to carry out their business, the role of fund boards is significantly different from that of boards of operating companies.   Initially, the Investment Company Act of 1940 (1940 Act) did not provide fund directors with many explicit obligations. The regulatory regime for open end and closed end investment companies has evolved over time, however, to rely extensively on judgments, evaluations, and valuations made by fund boards.  Not only does the 1940 Act require fund directors to police potential conflicts of interest by reviewing and approving the web of advisory and service provider contracts annually, but also they must fair value portfolio securities when necessary, and a whole host of regulatory exemptions for investment activities, fees, and taxes are conditioned on oversight by fund boards (and specifically by independent directors). 


This role continues to evolve, according to Ms. White, particularly with respect to overseeing risk management.  Technological and market changes require a new awareness by fund boards.  Chair White noted that, “firms today rely on technology and third-party service providers for many key functions, and a failure of just one of those functions can have potentially very serious consequences for funds and their investors."  And directors should be asking their funds’ service providers more questions about how they are understanding and planning for new risks and potential perils.  The key, according to Ms. White, is to keep asking the questions, and not become complacent once risk management plans are in place.


"There are some obvious initial questions to ask fund management like how will my fund’s and its service providers’ compliance policies and procedures, business continuity plans and back-up-systems address these situations? If your funds and their service providers do not have robust plans and procedures, you have some urgent business to attend to. But even funds that have such plans and procedures in place cannot just declare victory. No continuity planning or compliance policies and procedures, however thoughtful, comprehensive and well-intentioned, will address every issue and prevent all potential harm. Directors of funds should also be thinking about and asking fund managers whether these events could happen at your fund, how to prevent them from happening, and how to respond promptly and effectively if they do occur.”  


On the topic of complacency, Ms. White illustrated with a recent example of an enforcement action where fund directors were faulted for failing to perform properly their duty to fair value portfolio securities, and another where fund directors were insufficiently rigorous in their process for reviewing and approving their fund’s service provider contracts.  These failures were basic ones. And Ms. White made clear that, given the vital role of directors in the regulation of mutual funds and protection of investors, the SEC will not go easy when boards do not live up to their basic responsibilities. 


"These cases have generated some controversy and concern that the Commission acted too aggressively. I don’t agree, and I think a careful review of the facts involved should reassure conscientious directors. The message of these cases is simply that independent directors must be familiar with and carry out their responsibilities. In my view, the failures involved were basic ones. Unlike the directors in these cases, most directors do their jobs, carefully reviewing the briefing materials they receive, asking questions instead of rubber-stamping management recommendations, investigating potential inaccuracies, and following up on unfulfilled requests. And, for the funds to serve their investors' interests, directors must discharge their important gatekeeper function, assuring that proper procedures are followed and that the interests of investors are served. Our enforcement cases, while rare, serve to assure that these responsibilities are fulfilled."


The role of fund directors continues to evolve. Recent regulatory proposals related to fund liquidity standards and use of derivatives pose new challenges to fund boards.  While obviously fund boards are not expected to perform day-to-day management of a fund’s liquidity or derivatives activities, these new proposals both require boards to get involved in reviewing and approving policies to ensure compliance and manage risks.  


The proposed new derivatives rules for funds, if adopted, would require the board of a fund to approve one of two alternative portfolio limitations on the fund’s use of derivatives and to approve policies and procedures for managing risks associated with the fund’s derivatives transactions.


With regard to liquidity oversight, Ms. White urged directors to get more specific with their questions and better understand the issues.


"Directors should also be going beyond generalities and asking other specific questions. With respect to potential liquidity issues, boards should ask questions that will enable them to understand whether the funds’ investments are appropriately aligned with their anticipated liquidity needs and redemption obligations. In doing this, directors should consider the quality of the information that management provides to the board on liquidity, the frequency with which management reports to the board on liquidity, and how management of the funds monitors and manages liquidity risk.[17] Directors should also be asking themselves whether they understand any links that may exist between liquidity and valuation with respect to the funds they oversee and whether directors are appropriately focused on funds with strategies that may be more likely to face liquidity challenges. More broadly, advisers and fund boards should carefully consider whether an open-end fund’s investments and investment strategy are appropriate for a fund offering daily redemptions. "


Chair White concluded with praise for the work of fund boards, but urged fund directors to continue to ask the “tough questions” they need to be good stewards of investors’ assets.  At the same time, however, she assured her audience that micromanagement was not the answer either:  “much is expected of [fund directors] in [their] oversight role, but I also fully recognize the distinction from the role of management and that issues can occur even in funds with the strongest boards.”